Downing Street Economics- Part 1

“Bush wanted to remove Saddam Hussein, through military action, justified by the conjunction of terrorism and WMD. But the intelligence and facts were being fixed around the policy.” – Downing Street Memo

Rarely do you get to see the intellectual foundations of Very Serious People policy collapse as quickly and thoroughly as we have seen over the last few weeks with Austerity.

It is the Iraq War of Neoliberal Economics and like Iraq cost hundreds of thousands of lives, no less real because they died in hospital beds and Emergency Rooms or starving on the street instead of being blasted by high explosives or bullets and poisoned by depleted Uranium. The living casualties likewise lead lives of futureless despair; homeless, destitute, and crippled; preyed on the rapacious greed of an Elite of whom the most charitable thing you can say is that they are the dumbest people who ever walked the earth because otherwise it’s clear that they’re simply evil sociopaths.

While I might revisit the subject in greater depth I want to present you two analyses in the next couple of days, the first is by the famous Nobel Prize winner and NeoKeynesian Paul Krugman, the second by Modern Monetary Theorist Joe Firestone. Krugman’s is a little more populist in the sense of accessible to non-students of Economics, it’s also a little more personal since he’s considered a leading conventional proponent of the establishment counter argument.

As usual I’ll attempt to let them speak for themselves while highlighting what I think are their most significant points.

The intellectual edifice of austerity economics rests largely on two academic papers that were seized on by policy makers, without ever having been properly vetted, because they said what the Very Serious People wanted to hear. One was Alesina/Ardagna on the macroeconomic effects of austerity, which immediately became exhibit A for those who wanted to believe in expansionary austerity. Unfortunately, even aside from the paper’s failure to distinguish between episodes in which monetary policy was available and those in which it wasn’t, it turned out that their approach to measuring austerity was all wrong; when the IMF used a measure that tracked actual policy, it turned out that contractionary policy was contractionary.

The other paper, which has had immense influence – largely because in the VSP world it is taken to have established a definitive result – was Reinhart/Rogoff on the negative effects of debt on growth. Very quickly, everyone “knew” that terrible things happen when debt passes 90 percent of GDP.

Some of us never bought it, arguing that the observed correlation between debt and growth probably reflected reverse causation. But even I never dreamed that a large part of the alleged result might reflect nothing more profound than bad arithmetic.

But it seems that this is just what happened. Mike Konczal has a good summary of a review by Herndon, Ash, and Pollin. According to the review paper, R-R mysteriously excluded data on some high-debt countries with decent growth immediately after World War II, which would have greatly weakened their result; they used an eccentric weighting scheme in which a single year of bad growth in one high-debt country counts as much as multiple years of good growth in another high-debt country; and they dropped a whole bunch of additional data through a simple coding error.

Fix all that, say Herndon et al., and the result apparently melts away.

I was going to post something sort of kind of defending Reinhart-Rogoff in the wake of the new revelations – not their results, which I never believed, nor their failure to carefully test their results for robustness, but rather their motives. But their response to the new critique is really, really bad.

What Herndon et al did was find that the R-R results on the relationship between debt and growth were partly the result of a coding error, partly the result of some very odd choices about which data to exclude and how to weight the data that remained. The effect of fixing these lapses was to raise the estimated mean growth of highly indebted countries by more than 2 percentage points.

So how do R-R respond?

First, they argue that another measure – median growth – isn’t that different from the Herndon et al results. But that is, first of all, an apples-and-oranges comparison – the fact is that when you compare the results head to head, R-R looks very off. Something went very wrong, and pointing to your other results isn’t a good defense.

Second, they say that they like to emphasize the median results, which are much milder than the mean results; but what everyone using their work likes to cite is the strong result, and if R-R have made a major effort to disabuse people of the notion that debt has huge negative effects on growth, I haven’t noticed it.

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Finally, while they acknowledge the issue of reverse causation, they seem very much to be trying to have it both ways – saying yes, we know about the issue, but then immediately reverting to talking as if debt was necessarily causing slow growth rather than the other way around.

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So this is really disappointing; they’re basically evading the critique. And that’s a terrible thing when so much is at stake.

There’s going to be some back and forth about modeling strategies, data choice, and so on, and I’m pretty sure some people will try to say that R-R were basically right. At this point, however, it’s reasonably clear what the data will say, because others have created data sets that more or less match what R-R claimed to have looked at; e.g., this working paper from the OECD.

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There is a negative correlation between debt and growth in the data; we can argue about how much of this represents reverse correlation. There is not, however, any red line at 90 percent. And that red line has been crucial to R-R’s influence – without the “OMG, we’re going to cross 90 percent unless we go for austerity now now now” factor, the paper would never have had the influence it’s had.

It’s important to make a distinction between the R-R book “This time is different” and the paper. The paper got undeserved credibility from the book; now the book may be devalued by the paper. But they’re quite different.

The book had a sound empirical strategy: it focused only on extreme events, then described what happened around those events. Because of the severity of the shock, it was reasonable to infer that whatever happened around crises was in fact crisis-related, so problems of causation were sidestepped.

The paper didn’t do any of that – it just looked at simple correlations, without making any effort to untangle causation. It wasn’t worthy of the authors. And they behaved badly by digging in when critiques surfaced, rather than responding with a good-faith effort to sort out what was really happening.

Again, however, the larger story is the evident urge of Very Serious People to find excuses for inflicting pain.

I think it’s important to be clear that R-R aren’t the only ones at fault here. In particular, the people who cited their work don’t have the right to claim innocence, because how could they know that they were being given bad data?

The fact is that R-R was controversial right from the beginning; and very early on, although we didn’t know about the coding error, we knew that they had made a major blooper by citing the US contraction after World War II as an example of debt overhang, when it was actually just postwar demobilization. That should have made everyone suspicious from the start.

Yet the VSPs not only grabbed hold of the alleged result, they wrote again and again as if this highly disputed claim was a known fact.

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This is deciding what you want to believe, finding someone who tells you what you want to hear, and pretending that there are no other voices. It’s deeply irresponsible – and you can’t blame Reinhart-Rogoff for that mistake.

Reinhart-Rogoff quickly achieved almost sacred status among self-proclaimed guardians of fiscal responsibility; their tipping-point claim was treated not as a disputed hypothesis but as unquestioned fact. For example, a Washington Post editorial earlier this year warned against any relaxation on the deficit front, because we are “dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth.” Notice the phrasing: “economists,” not “some economists,” let alone “some economists, vigorously disputed by other economists with equally good credentials,” which was the reality.

For the truth is that Reinhart-Rogoff faced substantial criticism from the start, and the controversy grew over time. As soon as the paper was released, many economists pointed out that a negative correlation between debt and economic performance need not mean that high debt causes low growth. It could just as easily be the other way around, with poor economic performance leading to high debt.

In response, Ms. Reinhart and Mr. Rogoff have acknowledged the coding error, defended their other decisions and claimed that they never asserted that debt necessarily causes slow growth. That’s a bit disingenuous because they repeatedly insinuated that proposition even if they avoided saying it outright. But, in any case, what really matters isn’t what they meant to say, it’s how their work was read: Austerity enthusiasts trumpeted that supposed 90 percent tipping point as a proven fact and a reason to slash government spending even in the face of mass unemployment.

So the Reinhart-Rogoff fiasco needs to be seen in the broader context of austerity mania: the obviously intense desire of policy makers, politicians and pundits across the Western world to turn their backs on the unemployed and instead use the economic crisis as an excuse to slash social programs.

What the Reinhart-Rogoff affair shows is the extent to which austerity has been sold on false pretenses. For three years, the turn to austerity has been presented not as a choice but as a necessity. Economic research, austerity advocates insisted, showed that terrible things happen once debt exceeds 90 percent of G.D.P. But “economic research” showed no such thing; a couple of economists made that assertion, while many others disagreed. Policy makers abandoned the unemployed and turned to austerity because they wanted to, not because they had to.

Imagine one story – the story that R-R are implicitly telling – in which countries differ in their fiscal responsibility, this leads to different levels of debt, and those countries with high debt then suffer from slow growth. In that story, debt should be a pretty good predictor of future growth. You might also expect to see some correlation between debt and past growth, because debt levels change only gradually over time, and a country with high debt now typically had high debt and hence slow growth a few years ago too. But you’d expect the relationship between debt and future growth to be stronger than the relationship between debt and past growth.

Now imagine another story, in which countries aren’t that different in fiscal responsibility, but in which some countries for whatever reason – burst bubbles, declining fertility, structural problems coming from social change or something – have slower growth than others. Very plausibly, slow growth would lead to rising debt ratios, both because of slow growth in revenues and simply because the denominator of the ratio would be smaller. In this case past debt should be strongly related to past growth. You might also expect some relationship between debt and future growth, because growth tends to be “serially correlated” – countries that grew slowly in the past tend to keep growing slowly – but that relationship should be weaker.

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Clearly, the data look a lot more like story #2, in which slow growth causes high debt, than story #1, which is what everyone hyping Reinhart-Rogoff claimed.

And the everyone hyping Reinhart-Rogoff very much included Reinhart and Rogoff themselves. Matt O’Brien has the goods. It’s true that their papers never said outright that the relationship was causal, but they weren’t anywhere near that scrupulous in op-eds and other media presentations. And the truth is that the papers may not have stated causation flatly, but it was clearly insinuated. By trying to claim now that they never meant to imply such a thing, R-R are falling down seriously in the menschhood test.

One last thing: even if you take Dube’s forward-looking regression as a causal relationship, which you shouldn’t, notice how weak that relationship is in the relevant range. It looks as if raising debt from 50 to 150 percent of GDP, other things equal, reduces growth by around 0.1 percentage point over the next three years. This is the dreadful consequences that prevents us from doing anything about mass unemployment?

I see that both Tyler Cowen and Austin Frakt are offering explanations/excuses for the Reinhart-Rogoff affair in terms of the dynamics of wonk celebrity – basically, the pressure one feels under to take strong positions to attract and hold media attention. As an explanation, I think this has some merit; as an excuse, none at all.

What happened with R-R was that they came out with a sloppy paper that played to the spirit of the times. The sloppiness was immediately obvious from the way they highlighted slow US growth in the late 1940s as an illustration of the price of debt overhang, somehow missing the point about postwar demobilization. It took only a few days for critics to point out the correlation versus causation issue too.

Now, that was the point where R-R should have said, OK, we’ve been careless here, we need to rethink this, and backed off. But the paper was also a huge immediate hit with the austerians, and they got sucked in.

Notice, however, that the problem with the original wasn’t that it failed to convey the nuances. The problem was that it was just plain wrong – wrong about America after the war, wrong about what a debt-growth correlation means. (It turns out that there was other wrongness too, but that was enough).

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In particular, my hard-line views on policy in the current crisis – it’s a demand problem not a structural problem, there is no risk of crowding out, there is no risk of inflation from aggressive monetary expansion, there are large negative effects from austerity – aren’t simplifications of some more complex story, they are what my basic model and the lessons of history teach. Where there are things my “base” would like to believe but I’m not convinced, I say so – e.g., on the issue of whether inequality is a key factor holding back recovery.

So don’t make excuses for Reinhart and Rogoff by suggesting that somehow their flub was inherent in being prominent, that everyone does it. It wasn’t and they don’t.

While the Reinhart-Rogoff fiasco is fresh in our minds, it’s worth recalling the other paper that swept through the ranks of the VSPs, briefly becoming orthodoxy, what everyone knew, until people took a hard look at the data. Remember Alesina and Ardagna? That was the paper that supposedly showed that spending cuts were actually expansionary, because of Confidence (TM).

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It was also cited by everyone from Paul Ryan to George Osborne, more or less reproduced verbatim in the ECB monthly report, paraphrased by Jean-Claude Trichet, and so on.

But the IMF took a hard look (pdf) at the alleged evidence, and found it wanting. A-A (beware of papers where both authors have the same initial?) used a statistical technique that was supposed to identify episodes of large fiscal contraction; but if you compared that estimate with actual policy changes, it bore very little relationship.

What seems to have been going on was that the statistical filter was picking up extraneous effects, often correlated with good economic developments. For example, a stock market boom would increase revenue, reducing the deficit; A-A would count this as a contractionary fiscal policy, and marvel at the expansion that followed.

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The point, as with Reinhart-Rogoff, was that the paper told austerity-minded people what they wanted to hear, and they seized on its message without carefully examining the underlying research.

Now, A-A didn’t crash-land the way R-R did, because it didn’t contain anything as easily ridiculed as the Excel error. Instead, it was damaged by the IMF study, and thereafter got gradually discredited as the disastrous results of austerity in Europe became apparent. So there wasn’t a sudden moment of realizing that the emperor wore no clothes. Nonetheless, the underlying story, of dubious research put on a pedestal because it was what the VSPs wanted, was the same.

The true test of an analytical framework is how it performs in unusual or extreme circumstances, how well it predicts “out of sample”. What we have experienced since 2007 is a series of huge policy shocks – and basic macroeconomics made some very counterintuitive predictions about the effects of those shocks. Unprecedented budget deficits, the model said, would not drive up interest rates. A tripling of the monetary base would not cause runaway inflation. Sharp government spending cuts wouldn’t free up resources for the private sector, they would depress the economy more than one-for-one, so that private spending as well as public would fall.

Quite a few people considered these predictions not just wrong but absurd; they braced for soaring rates and inflation, they waited for the good news from austerity. But the model passed the test with flying colors. Remember how Romer and Bernstein were savaged for assuming a multiplier of around 1.5? Four years later, after much soul-searching from the IMF about why it underestimated the costs of austerity, estimates seem to be converging on a multiplier of … about 1.5.

So how is it that economists look so bad? The answer is that too many prominent economists chose, for one reason or another, to reject the existing model. Maybe they were just trying to score points by being different; maybe they were sucked in by the approbation of the VSPs, the rewards that came from telling important people what they wanted to hear. In any case, we had Alesina/Ardagna saying that austerity is actually expansionary thanks to confidence effects; Reinhart/Rogoff saying that debt has terrible effects on growth via unexplained channels. This stuff was creative, different, deeply appealing to powerful people – and dead wrong. If you stayed with Econ 101, you got it right, if you went with the trendy stuff you made a fool of yourself.

When it comes to inflicting pain on the citizens of debtor nations, austerians are all steely determination – hey, it’s a tough world, and hard choices have to be made. But when they or their friends come under criticism, suddenly it’s all empathy and hurt feelings.

We saw that in the case of Olli Rehn, whose friends at the European Commission were outraged, outraged when I pointed out, using slightly colorful language, that he was repeating an often-debunked claim about economic history. And today we see it in Anders Aslund’s defense of Reinhart and Rogoff against what he calls a “vicious” critique by Herndon et al.

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But then, why would he describe Herndon et al as “vicious”? Their paper was a calm, reasoned analysis of how R-R came up with the famous 90 percent threshold; it came as a body blow only because of the contrast between the acclaim R-R received and the indefensible nature of their analysis.

What I think is happening is that austerians have put themselves in a box. They threw themselves – and their personal reputations – completely behind the various elements of anti-Keynesian doctrine: expansionary austerity, critical debt thresholds, and so on. And as Wolfgang Munchau says, the terrible thing was that their policy ideas were actually implemented, with disastrous results; on top of which their intellectual heroes have turned out to have feet of clay, or maybe Silly Putty.

As I see it, the sheer enormity of their error makes it impossible for them to respond to criticism in any reasonable way. They have to lash out any way they can, whether it’s ad hominem attacks on the critics or bitter complaints about bad manners.

We now reach Krugman’s The Snicker Factor which highlghts the Colbert piece I embedded above and though Herr Doktor Professor has more to say this is already quite long enough so I’ll save the rest for another day.